# Advisor in the Nation
RIC EDELMAN’S Ranked by Barron’s†
Conversion Conundrum ††
A SPECIAL REPORT UPDATED JANUARY 2011
You Can Convert Your IRA to a Roth
But should you?
n 2010, Congress began letting everyone convert their believe that conversion is necessarily in everyone’s best
Deductible and Non-Deductible IRAs to a Roth IRA. (Pre- interests. Let’s examine the notions involved with convert-
viously, conversions were limited to those with Adjusted ing your IRA to the Roth.
Gross Incomes of less than $100,000.)
Conversion Notion #1: It Makes Sense If Your Current
Converting is alluring. If you don’t convert, you’ll pay taxes Tax Bracket Is Low.
when you make withdrawals in retirement. And you must Some people are temporarily in a low tax bracket. This
start making those withdrawals in your early 70s. But with- can be caused by a variety of reasons: divorce, job loss,
drawals from Roth IRAs are tax-free, and there’s no require- temporary work assignment (such as in a tax-free
ment to begin withdrawing money at any age. continued on page 2
Those facts suggest that converting to a Roth is a no-
Guess Who Is Sure
brainer. But before you act, read the fine print: The money
you convert is fully taxable (which explains why future
to Profit from Roth IRA
withdrawals are tax-free; instead of paying the taxes later,
you pay up front).
So the choice is yours: Pay the tax now on the current bal-
ance so that future withdrawals are tax-free, or pay the tax
later when you make withdrawals from the (theoretically The financial industry wins, even if you don’t
s we approach and enter the new year, you’ll be
So should you pay now or pay later? It’s a simple question, hearing more and more about the idea of convert-
but as with so many issues in the field of personal finance, ing your IRA to a Roth IRA. The idea, though, is not
the answer requires substantial analysis. Getting it wrong necessarily good for you. So why all the hubbub?
could cost you tens of thousands of dollars in unnecessary
and premature taxes, and many tens of thousands more in Simple: The idea is terrific for the financial services industry.
lost wealth. Wall Street brokerage firms, mutual funds and insurance
companies all stand to profit immensely from consumers
While my colleagues at Edelman Financial and I agree with who convert their IRAs to Roths. Ditto for stockbrokers,
all those who say that the Roth Conversion Conundrum insurance salesmen and financial advisors. Many in the
is a timely issue that investors should address, we do not continued on page 7
Barron’s ranking “Top 100 Independent Financial Advisors” (Aug. 28, 2010 / Aug. 31, 2009) based on the quality of the advisors’ practices, including client retention and
compliance record, contribution to the firm’s profitability, and the volume of assets overseen by the advisors and their teams.
Try saying that 10 times fast!
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RIC EDELMAN’S SPECIAL REPORT: ThE ROTh IRA CONvERSION CONUNDRUm
You Can Convert Your IRA to a Roth continued from page 1
hazardous zone), high and sudden (but short-term) medi- Conversion Notion #6: It Could Require You to File
cal expenses and more. If you are currently in the 15% fed- Estimated Payments.
eral income tax bracket or less and have reason to believe The IRS expects you to pay your taxes in the calendar quar-
that your income will rise in future years, placing you in a ter in which you earn the money. Ordinarily, this is handled
higher bracket, converting now makes sense. for you by your employer (through payroll deductions). But
if you convert a large IRA, you could be required to file IRS
Conversion Notion #2: It Could Increase Your Form 1040-ES quarterly, making payments each quarter. If
Children’s Inheritance. you don’t, you could incur interest and penalties.
By converting your IRA to the Roth, you pay the taxes now.
If you want your children or grandchildren to inherit the Conversion Notion #7: You May Not Know How Much
account when you die, they’ll receive the money without in Taxes You Owe Until Next Year.
having to pay income tax. With proper estate planning, Surprisingly, if you own both Deductible and Non-De-
their inheritance can be increased substantially compared ductible IRAs and you convert only the Non-Deductible
to a traditional IRA. Of course, this Roth Conversion feature IRA, you won’t know how much you owe in taxes until
is of primary value to your heirs, not you. next year. That’s because the IRS considers conversions
to consist proportionately of each type of IRA you own.
Conversion Notion #3: It Could Increase Your Federal Let’s say you have $100,000 in IRAs — $40,000 in after-tax
Income Taxes. contributions and $60,000 in pre-tax contributions. To
If you’re in a low tax bracket, be aware that converting determine how much of the conversion you’d have to pay
could push you into a higher bracket — and possibly even taxes on, you divide the pre-tax amount in the account by
the highest bracket of 35%. That’s because the amount you the total ($60,000/$100,000 = .60). Thus, you would have
convert is added to your taxable income. So if you earn to pay taxes on 60% of any money you convert. So if you
$20,000 and you convert a $200,000 IRA to the Roth, your decide to convert $40,000, you’d pay taxes on $24,000. At
income is now $220,000 — putting you in the 33% income an ordinary tax rate of 28%, that’s $6,720.
tax bracket. This would affect your overall taxable income,
not just the dollars involved in the conversion. But this calculation is based on the year-end value of your
IRAs — including the money you converted — not their
Conversion Notion #4: It Could Increase Your State value on the day you converted. So if your account increas-
Income Taxes. es in value by year-end (or if you rollover a pre-tax 401(k)
If you live in a state with an income tax and you convert, into an IRA) you might pay more in taxes than you expect.
you’ll owe state taxes. If you later move to a state that has
no income tax and convert then, you’ll avoid that state Conversion Notion #8: It Doesn’t Necessarily Increase
income tax. Your Wealth.
Conversion is revenue-neutral; whether you convert or not,
Conversion Notion #5: It Could Cause You to Pay a your future account balance (after taxes) will be the same.
10% IRS Penalty. Don’t believe me? Here’s the math: Say your Deductible IRA
Say you convert a $100,000 IRA to the Roth, causing you has $100,000 and it doubles between now and retirement,
to owe $35,000 in federal income taxes. Are you able to to $200,000. You then withdraw the money, paying 35%
pay the tax from earned income or money held in other in taxes. That’s $70,000, leaving you with $130,000. But
accounts? If you use money held in the IRA, and if you’re instead, let’s say you convert your current IRA of $100,000
under age 59½, you’ll owe a 10% IRS penalty in addition to to the Roth. You pay 35% in taxes on the current balance.
the tax itself. That’s an additional $3,500. (And we haven’t That’s $35,000, leaving you with $65,000. This amount then
mentioned state taxes — paying those from the IRA could doubles so that by retirement you have $130,000 — and all
further increase your taxes and IRS penalties.) withdrawals are now tax-free. So whether you convert or
continued on page 3
* Figures quoted are for illustrative purposes only and are not necessarily indicative of past or future results of any specific investment.
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RIC EDELMAN’S SPECIAL REPORT: ThE ROTh IRA CONvERSION CONUNDRUm
You Can Convert Your IRA to a Roth continued from page 2
not, you end up with the same amount of money. The only you no value. In other words, you might actually be better
difference is that one strategy has you pay $35,000 in taxes off financially by having some taxable income rather than
now, while the other has you pay $70,000 later. But the net 100% tax-free income.
after-tax value is the same.
Conversion Notion #12: It Could Cause Your Taxes to
Conversion Notion #9: The Amount of Wealth Rise Even Further.
Enhancement You Expect to Get Depends on Your In the year you convert, your income rises. That creates the
Tax Rate Assumptions. risk that you might lose some or all of your personal exemp-
Of course, the above assumes that your current tax rate tions and itemized deductions — and some (or more) of
stays the same — and that’s quite an assumption. If your your Social Security benefits may become taxable as well.
future tax rate is higher, then you benefit by converting and All this could cause your tax bracket in the year of conver-
paying taxes at today’s lower rate. And the higher you think sion to be even higher than you anticipate.
your future tax rate will be, the more you benefit by con-
verting. Likewise, if you think your future rate will be lower, Conversion Notion #13: Converting at the Wrong Time
converting reduces your future wealth. Could Cause You to Pay More Taxes Than Necessary.
A lot of people who converted their IRAs in early 2008 later
Don’t be so sure that your tax rate in retirement will be regretted it. Because of the economy, many people dis-
higher than it currently is. Although President Obama has covered that their account values were lower at the end of
stated that he plans to increase tax rates, any such changes the year. But if you converted in January 2008, you had to
are irrelevant unless you plan to withdraw money from pay taxes based on the value of the account at that time —
your IRA during his term in office. If you are retiring in 20 even though the account might have been worth 40% less
years, President Obama’s tax law will be as outdated (and 12 months later.
irrelevant) as Jimmy Carter’s is today. Thus, all assumptions
about future tax legislation are sheer speculation — hardly To protect you against the risk that the account might drop
justification for making a sound financial decision. in value shortly after you convert, tax law allows you to
“recharacterize” your account. In other words, you get to
Conversion Notion #10: It Could Increase Your “unconvert” your IRA from the Roth back to the Deductible
Medicare Premium. or Non-Deductible IRA you originally held. You must do
If you are covered by Medicare, your Part B premium is this no later than the extended due date for the tax year in
based on your income. Converting increases that income which you converted. After you recharacterize, you can then
(if only for a year or two), which could add hundreds of convert all over again — this time at the new lower market
dollars to your monthly Medicare costs. value. And you must wait until the later of (a) the beginning
of the year following the year in which the amount was
Conversion Notion #11: It Could Cause You to Pay converted or (b) the end of the 30-day period beginning on
More in Taxes Than You Should. the day you transfer money from the Roth back to a tradi-
Some investors do everything they can to reduce their tional IRA.
income taxes. They save all their money in IRAs, employer
retirement accounts, tax-free municipal bonds — and the Here’s an example: Say your Deductible IRA owns stock
Roth IRA. By converting their IRAs and employer accounts mutual funds and on January 1, 2008, they were worth
to the Roth, they are able to generate income in retirement $300,000. You convert, owing $120,000 in taxes. A year
that is 100% tax-free. later, due to the economy, your stock funds are worth only
$180,000. You still owe $120,000 to the IRS — leaving you
But avoiding taxes so completely isn’t necessarily a good with a paltry $60,000.
result. That’s because the tax code offers a variety of tax
deductions, such as the standard deduction, plus deduc- So you recharacterize. This turns your account back into a
tions for mortgage interest, real estate taxes, charitable Deductible IRA. It’s worth $180,000 (due to the market’s de-
contributions, being older than 65 years of age and other cline). You convert all over again — and this time, you owe
reasons. If all your income is tax-free, these deductions offer taxes of just $72,000 (assuming the same tax bracket as in
continued on bottom of page 4
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You Can Convert Your IRA to a Roth continued from page 3
the above calculation). Recharacterizing has just saved you part of an annuity, you are essentially splitting off part
$48,000. Powerful, eh? of your annuity to create a new IRA. This sounds simple
enough, but breaking off a piece of the annuity is the same
While it’s always possible that the stock market might as making a withdrawal. Depending on your annuity, a
decline 38% in a single year (like it did in 2008), it’s unlikely premature withdrawal could trigger the annuity to lock
that you will place your entire Roth IRA into stocks. It’s more in a living benefit payout percentage earlier — and there-
likely that you will diversify among a variety of asset classes. fore much lower — than you had expected or planned. It
It’s also likely that some of those asset classes will perform could also cause the annuity to stop providing guaranteed
better than others. It’s possible that some might even lose growth.
Conversion Notion #15: The Money You Convert
Therefore, you might find yourself wanting to recharacterize Becomes Untouchable for Five Years.
some of your money, but not all of it. If all your investments When you make a direct contribution to a Roth IRA, you
are held in a single Roth IRA, you can’t. Thus, you’d have can withdraw that money at any time without penalty.
to create multiple Roth accounts — one for each of your The earnings, however, must stay in the account until you
investments. If you have 20 stocks, you’ll need 20 Roth IRAs. are 59½ — or you’ll incur ordinary income tax rates plus a
If you have 10 mutual funds, you’ll need 10 Roths. 10% penalty.
Also, you should automatically place yourself on extension The rules for Roth IRA conversions are different. If you con-
for the tax year you convert to a Roth, being sure to pay any vert money to a Roth IRA and are under age 59½, you can’t
taxes owed by April 15. withdraw the rollover contributions for five years. If you
These two approaches — establishing separate Roth IRAs do, you’ll face a 10% penalty. (The rules for distributions of
and filing an extension — will grant you maximum flexibil- earnings are the same as with direct contributions.) There
ity to recharacterize a given asset if needed. But it will also are exceptions for medical expenses, first-time homebuyers,
exponentially increase your paperwork and record-keeping disability, and higher education. And each conversion has
obligations, as well as increase your costs if you pay annual its own five-year holding period.
custodial fees for each IRA account. Conversion Notion #16: It Could Impact Financial Aid
So if you don’t isolate each holding in a separate Roth IRA, for Your College Student.
you might later wish you had done so. And if you do, you IRAs aren’t included among your assets when a college
might later wish you hadn’t. Time will tell. calculates a financial aid package. However, when you con-
vert to a Roth IRA, the money shows up on your tax forms
Conversion Notion #14: If You Have an Annuity in Your as income for that year. If your income is artificially inflated
IRA, Things Get Complicated. when you fill out financial aid forms, you’ll have to explain
Your tax obligation isn’t limited to the cash value of the the situation to the school, and they may or may not take
contract. Instead it’s determined by the fair market value of that information into consideration.
the annuity, which is the cash value of the contract on the
day you convert plus the actuarial net present value of any Conversion Notion #17: Not All Funds Can Be
living or death benefits. (Your insurance company can cal- Converted.
culate your present net value for you.) For example, if your Inherited IRAs, required minimum distributions, 72(t) pay-
annuity has a cash value of $50,000 and the death benefit is ments, hardship distributions, corrective distributions of
worth $200,000, you’ll owe taxes on $250,000. excess deferrals, deemed deferrals and dividends from
employer securities cannot be converted. ❖
Take extra care if you are only partially converting your
variable annuity. When you convert an entire annuity, the
annuity itself remains intact. But when you convert only
EFS does not provide tax advice. Information regarding tax matters is of a general nature only, and is not to be construed as constituting specific advice. EFS recommends that clients
consult a tax advisor for advice concerning tax issues.
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RIC EDELMAN’S SPECIAL REPORT: ThE ROTh IRA CONvERSION CONUNDRUm
Should I Convert to a Roth?
Ric gives these case studies a thumbs-up or thumbs-down
Q Let’s say I have $250,000 in an IRA. If I convert it when
the new rules take effect, I’m going to pay taxes at the
highest tax bracket, correct? But if I don’t convert and wait
Converting all your money into tax-free accounts might
not be in your best interests.
20 years until I retire, I’ll only take out 5% per year, or about Of course, it also depends on whether you believe your
$1,000 per month, to support my income. I’d like to hope that future tax bracket will be higher than the tax bracket you’re
the tax rate for $12,000 in 20 years is less than the rate on in when you convert.
$250,000 today. Therefore, I do not plan to convert. Am
Q I’m thinking about converting my
traditional IRA of $300,000 to a Roth
A You may or may not be in the IRA and paying the taxes now. The reason
highest tax bracket, which is 35% I’d do this is to reduce the possible tax
in 2011 and begins with taxable liability and other complications for when
income above $379,150. While my four children inherit it. I’m 71 — what
I can’t say for sure that you do you think?
will be correct, I do agree
with your thought process.
If I were you, I’d take the A It’s probably a bad idea. If you con-
vert the $300,000 in your IRAs into
a Roth IRA, you will pay taxes now on all
the money, probably at the top bracket
Q I was talking to someone of 35%. However, when your children
at the bank, and he said get their inheritance, they will each get
that if I convert my entire IRA to a only a quarter of that money — and with
Roth IRA, all my retirement income proper estate planning, they can pay
will be tax-free. It sounds like a great plan. Should I go for it? the taxes due over the course of their lifetimes. It’s quite
possible that they will pay taxes at a much lower rate than
A If all your retirement income is tax-free, you suffer
from a “lost opportunity cost” if you continue to have
what you’d pay now.
tax deductions. For example, say you have a 6% mortgage.
That loan is tax-deductible, which reduces its cost for Q If my IRA is worth less now than when I opened it, can I
take the whole thing and dump it all into a Roth without
any tax implications?
many taxpayers by about a third, to only 4%. But to enjoy
this savings, you must have taxable income. If you don’t,
you’ll pay the full cost of the mortgage. Ditto for medical
expenses, property taxes and other tax breaks: To enjoy A Yes, if the account is a Non-Deductible IRA and it’s
the only IRA you own, because in that case you have
already paid taxes on the money.
these benefits, you need taxable income. Be careful before
deciding to set up all your income as tax-free.
No, if the account is a Deductible IRA. That means you’ll
This demonstrates why determining whether it’s beneficial pay taxes when you convert to a Roth.
to convert your account can get absurdly complicated. continued on page 6
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RIC EDELMAN’S SPECIAL REPORT: ThE ROTh IRA CONvERSION CONUNDRUm
Should I Convert to a Roth? continued from page 5
Q My wife and I are both 40 years old. Our income is more
than $180,000, so we aren’t eligible to contribute to a
Roth or Deductible IRA. We’re both employed and we max
unusual — it’s rare to find a family making as much as you
are without having any money in IRAs.
out our 401(k) plans, and we also contribute to a 529 plan.
I’m interested in having us contribute $5,000 each to a Non- Q I’m thinking about converting my IRA to a Roth IRA
this year. I was laid off earlier this year, so our taxable
income for 2011 will be extremely low, about $20,000.
Deductible IRA this year and convert it to a Roth in 2011.
We have no money in IRAs right now.
A Looks like you found the bright spot of losing your job,
A For 2011, you can contribute $5,000 to a Roth IRA and the Roth conversion seems to make sense in your
if your income is under $169,000 for married couples case. Since your income for this year is artificially low and
filing jointly and $107,000 for singles. You can contribute you’re anticipating getting back to work next
to a Deductible IRA if your income is under $169,000 for year (and resuming your previous income),
married couples filing jointly and you are not converting now might make sense. But keep in
covered by a retirement plan at work mind that the amount you convert
but your spouse is covered. constitutes income. If you file
If you are covered by a a joint tax return with your
retirement plan spouse, you’re in the 15%
at work, you tax bracket only if your
can contribute taxable income stays at
to a Deductible IRA if your $69,000 ($34,500 if filing
income is under $90,000 for single) or less. Thus, you can
married couples filing jointly and convert only about $49,000
$56,000 for singles. If your in- and remain in that bracket; if
come is more, you might be able your IRA is $200,000 and you
to contribute smaller amounts; convert the entire amount, you’ll
those aged 50 or older contribute pay a 33% tax even though you
an extra $1,000. earned only $20,000 this year.
Assuming you are eligible to contribute, So if your account is large, convert now only the
then proceed — and I say this only because you amount that lets you stay in the 15% or lower tax
don’t have any IRAs at all right now. My answer would be bracket, assuming you believe you will be in a
different if you had both Deductible and Non-Deductible higher tax bracket in the future, and then convert the rest
IRAs. That’s because the IRS forces you to move money next year to allow you the chance to delay the tax bill even
from them proportionately; you can’t move Non-Deduct- further.
ible assets without also moving a portion of assets in
Deductible accounts. That, in turn, would force you to incur As you can see, there isn’t a simple answer. Further analysis
taxes now. is necessary to determine whether or not you should con-
vert, how much to convert and when. ❖
So go ahead and contribute to the Non-Deductible IRA,
but make sure you convert the money to the Roth IRA
when the rules permit it. And know that your case is
Ric Edelman is Chairman and CEO of Edelman Financial Services LLC and Co-CEO of The Edelman Financial Group (NASDAQ: EF) and a member of its Board of Directors. he is an Investment Advisor
Representative who offers advisory services through EFS, a registered Investment Advisor. Ric is also a Registered Principal of and offers securities through Sanders morris harris Inc., an affiliated broker/
dealer, member FINRA/SIPC.
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RIC EDELMAN’S SPECIAL REPORT: ThE ROTh IRA CONvERSION CONUNDRUm
Guess Who Is Sure to Profit from Roth IRA Conversions? continued from page 1
field, it seems, may view the Roth IRA
conversion as a huge opportunity to
increase their assets under manage-
ment and generate new fees and
How so? Simple, again: Commission-
based brokers and insurance agents
could reap a fortune by getting
consumers to shift their IRA dollars
into Roth accounts. Brokerage firms,
mutual fund companies and insurers
who sell annuities all earn profits by
selling investments to consumers too.
And what about fee-based advisors? their businesses. Smart advisors will are required to serve as fiduciaries —
They earn a living (like us) based on make the most of it.” meaning they must place their clients’
their assets under management. best interests first. Instead, if the hype
The more assets under management, Here’s another example. I recently surrounding the financial industry is
the more money the advisor makes. received mail from something called any indication, many advisors seem to
By convincing consumers to shift the “Roth IRA Institute.” The envelope be placing their own interests ahead
their IRAs (held elsewhere) to a Roth contained a six-page letter written by of their clients’.
IRA managed by the advisor, the a CPA who trademarked the name;
advisor increases his AUM and thus his “institute” encourages financial Consider that a 2009 survey from
increases his income. advisors to sign up for his marketing Fidelity Investments found that 34%
program to learn how to convince of investors don’t understand the
No wonder the industry is pushing consumers to convert to the Roth IRA. tax implications of Roth IRA conver-
Roth conversions. Says the letter, “The Roth IRA conver- sions and 28% incorrectly think that
sion is the perfect tool for selling contributions to Roth IRAs are tax-
Want evidence? Consider the Sept- annuities of $100,000 or more. Of deductible. Clearly, tax rules pertain-
ember 6, 2009, issue of Investment- course, this program will also attract ing to Roth IRAs are confusing. Add an
News, a weekly newspaper directed less wealthy prospects, but since I aggressive sales pitch by the industry
at financial advisors. Its headline make more money with the same and…well, you wind up with an op-
and subhead read, “Using Roth IRAs work, I prefer going after high-net- portunity for abuse.
to Build Your Business — Advisors worth clients.” The letter also says that
who target conversions … can lure the Roth IRA Conversion is “a great So when you start seeing or hearing
prospects.” The article explains how tool to attract the right type of buyer ads that promote Roth IRA conver-
advisors can use Roth conversions to of life insurance products. The truth is, sions or seminars devoted to the
make more money for themselves, no matter what the financial product topic, remember that the promoter
with no mention of whether Roth or service you are selling or providing, always benefits from the idea, but
conversions actually benefit clients. good prospects will be attracted by that doesn’t mean you will.
The article contains such statements Roth IRA conversion expertise.”
as, “The advisers who get to their cli- Only a thorough analysis of your
ents and prospects first can position We consider these materials to be situation can determine whether con-
themselves as experts, and will gain unconscionable. Financial advisors verting your IRA to a Roth is in your
a competitive advantage” and “The are not supposed to twist changes best interest. If an “advisor” recom-
tax law change presents advisors with in tax law into marketing programs mends that you convert before com-
a one-time opportunity to launch a designed to sell insurance products. pleting such a review, odds are good
marketing plan designed to expand Rather, registered financial advisors that the person he or she is focusing
on isn’t you. ❖
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